Canada: Tax Free Capital Dividends – Elections And Penalties – A Toronto Tax Lawyer Analysis

Last Updated: November 21 2017
Article by David Rotfleisch

Capital dividends are a useful method for Canadian private corporations to distribute tax free funds to their shareholders. Corporations can declare these capital dividends which their shareholders can receive tax-free. However, a corporation should be cognizant of the amount in their capital dividend account because any capital dividends issued in excess of the amount in a corporation's capital dividend account are subject to an additional tax of 60%. Where a corporation has issued excess capital dividends and has incurred the extra 60% tax, the corporation can still make an election for the excess amount to be treated as a separate taxable dividend and avoid having to pay the 60% tax.

Capital Dividends

Capital dividends are a form of return of capital to a shareholder of a corporation and are, therefore, distributed to shareholders tax-free. In order to issue a capital dividend, a corporation must issue a dividend and elect under s.83(2) of the Income Tax Act for the entire dividend to be considered a capital dividend and file the requisite documents with the Canada Revenue Agency (CRA). Specifically, a corporation needs to file Form T2054, a certified copy of the directors' resolution authorizing the capital dividend declaration, and schedules showing the computation of the amount of the corporation's capital dividend account immediately before the election (Schedule 89 can be used for this calculation).

The election must be made by the earlier of two dates: 1) the day on which the dividend becomes payable; or 2) the first day on which any part of the dividend is paid.Additionally, a corporation can only issue a capital dividend up to the amount in the corporation's capital dividend account. The capital dividend account, in simple terms, comprises of the non-taxable portion of certain types of income that the corporation has earned. For instance, only 50% of a capital gain is taxable, thus, if a corporation has a capital gain of $100,000, $50,000 would have been taxable and $50,000 non-taxable. The non-taxable amount would be added to the corporation's capital dividend account at the end of the corporate year end, and a tax-free capital dividend could then be issued for up to that amount to the corporation's shareholders. Other types of income that comprise a corporation's capital dividend account beyond the non-taxable portion of capital gains are capital dividends received by the corporation, the non taxable portion of eligible capital amounts, life insurance policy proceeds, and certain trust distributions. Learn more about capital dividends by contacting our top Toronto tax law firm.

Late Filed Elections for Capital Dividends

Where the filing deadline for a capital dividend has already passed, a late filed s.83(2) election can still be made. The same schedules and forms must be filed as with an on time capital dividend election, with the addition of the estimated late filing penalty amount. The late filing penalty is calculated as the lesser of $41.67 or 1/12 of 1% of the amount of the dividend for every month or part-month between the day the late-filed election is made and the filing due date. For example, if the election was filed 1 year late, the penalty would be $500 or 1% of the amount of the dividend, whichever is less. Practically speaking, that means if the dividend is more than $50,000, you will be penalized $41.67 per month or part-month and 1/12 of 1% of the dividend per month for any dividend less than $50,000. However, be warned that if the CRA sends a written request to a taxpayer to make a late-filed election for a particular capital dividend, the taxpayer has 90 days from the request to make the late-filed election and, failing to make that election, the taxpayer is barred from making a late-filed election for that particular capital dividend in the future.

Excess Capital Dividend Penalties

Where a capital dividend is declared that is greater than the amount in the corporation's capital dividend account (CDA), an excess capital tax is levied on the corporation. The shareholder(s) receiving the capital dividend still receive the entire amount, excess amount included, tax-free. However, the corporation is penalized with an additional tax equal to 60% of the excess amount under s.184 and s.185 of the Income Tax Act. This might occur because the corporation's capital dividend account was miscalculated or even as a result of a re-assessment lowering the amount in the corporation's capital dividend account, or a timing error with respect to the computation of the CDA by including the capital gain prior to the corporate year end. Fortunately, s.184(3) allows the corporation to make an election to treat the excess amount of a capital dividend as a separate, taxable dividend. This election must be made within 90 days of the notice of assessment in respect to the excess capital dividend tax. Notably, the separate taxable dividend is considered to have been received by each shareholder at the time the original dividend was issued.

Tax Tips – Capital Dividend Elections

In order to elect for a dividend to be a capital dividend, keep in mind that the election must apply to the entire dividend. Furthermore, there are specific deadlines and requirements for specific forms and schedules to be filed in order for the election to be considered valid. Issuing a capital dividend greater than the amount in a corporation's capital dividend account also results in a hefty 60% tax on the excess amount. With all these potential pitfalls, it is important to make sure that you have met all the requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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